October CPI may have surprised, but it was just a reaction to the drop in energy costs

A few days after the surprisingly steep -0.7% drop in the October CPI was announced, the Bank of Israel's monetary policies are becoming clearer. Analysts had thought the central bank might cut local interests by a fairly steep 0.5%, but are changing their mind.

Stanley Fischer, the central bank's governor, is expected to respond to the exceptional decline in inflation, the largest October drop in Israel's history, by lowering interest rates for December by only 0.25%.

After that cut, the Bank of Israel is likely to shave back another 0.25% from interest afterwards.

In its last announcement of interest rates, the bank said that if the economy did not worsen, it would consider another rate cut.

Most pundits agree this was a clear signal that it would to lower interest by 0.25 basis points for December, to 5%.

In the meantime the surprise CPI was published - not only did the situation not worsen, it actually improved significantly in terms of inflation.

Nevertheless, the bank is not expected to change its original decision to lower rates by 0.25%. The feeling among the bank's management is that it will deviate from the 0.25-percent rate change only in exceptional situations; and in spite of the surprise, October's inflation drop is not such an exceptional occurrence.

It is viewed only as a correction in response to lower energy costs. In the meantime, oil prices have stabilized. Similarly, the large price increases at the beginning of the year were not considered extreme, since they were a direct result of the rise in world energy prices.It is very difficult to calculate the effect of world energy prices on consumer prices. There is even research - including a famous work by Ben Bernanke, the U.S. Federal Reserve Board chairman, about the 1970s energy crisis and the resulting American recession - that says central banks should ignore inflation changes stemming from energy prices when setting monetary policy.

In his research, Bernanke showed that the Fed erred in its response to the rise in oil prices, and in doing so made the recession worse. Therefore the Fed, with Bernanke at the helm, did not respond to this year's price jumps.

According to this school of thought, the Bank of Israel will probably try to ignore oil prices and will not make an exceptional rate change.

Also, a further drop in interest would set Israeli rates below the current U.S. rates, which could affect the stability of the shekel. In addition, short-term inflation forecasts have risen from 1.3% to 1.6%, and long-term forecasts are at 2%. These estimates all point to the same conclusion - a 0.25-percent decrease in interest rates.

Finally, one more interesting number that will influence the central bank is the Central Bureau of Statistics' announcement last week that economic growth was down only 1.6% in the third quarter as a result of the Lebanon war. This was much less than the bank's estimate of 3%, and further supports the central bank's view that there is no need for a larger rate cut.

Jonathan Lis adds: Fischer testified a few days ago in the matter of Prime Minister Ehud Olmert's involvement in the Bank Leumi privatization affair. His testimony to the special police investigative team was meant to provide further information on Olmert's activities.

Fischer is not in any way considered a suspect nor is he considered to be involved in any improprieties. Other senior officials have also been summoned to testify in recent days, including a number of Finance Ministry employees who were involved in preparing the Leumi tender.

The investigative team was established at the beginning of the month after the State Comptroller, Micha Lindenstrauss, requested that Attorney General Menachem Mazuz open an investigation into whether Olmert intervened in the tender. The investigation is expected to end within a few days.

Fischer's spokesman refused to comment on the matter.

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